Fed Hubris: Central Bank Ignores That It is on Thin Political Ice

A shot across the Fed’s bow from Simon Johnson, former IMF chief economist and bank critic, on the surface looks to be a good bit of news. Johnson, in a recent Project Syndicate article, warns that the notoriously cloistered central bank is overly confident about its political position.

Although Johnson is constrained by both space limits and Project Syndicate’s anodyne style, his warning is clear: the Fed is more powerful than ever despite having been wretchedly incompetent in the runup to the crisis. Many would say it has compounded its incompetence by going into “if the only tool I have is a hammer, ever problem looks like a nail” mode with ZIRP and QE. The Fed was not only silent when its input would have mattered a great deal, in the fiscal stimulus fight of 2009, but Bernanke called for deficit cutting in 2012, even as he had his foot firmly on the not-very-effective QE accelerator. The result is a flaccid economy, bubbles in many financial assets and destabilizing hot money flows sloshing through developing economies.

As a result of this misrule, Johnson contends the central bank is much closer than it recognizes to losing its vaunted independence. Johnson points out that the right wing is keen about restricting the Fed’s freedom of action, and that they are a much more serious threat than the Fed appears to understand. What happens if the Republicans gain a majority in the Senate in the midterms?

Even though Johnson is in some ways very critical of the central bank, he if anything overstated its base of support. The hostility towards the monetary authority among conservatives is perverse, given how much the Fed has done for the wealthy by showing such solicitude about asset prices. Nevertheless, it is not just the right that is unhappy with the Fed. It is pretty much anyone to the left of mainstream Democrats. Orthodox folks tend not to recognize its existence since its members are seldom welcome in polite DC company. Remember, it was Ron Paul and Alan Grayson who teamed up on Audit the Fed. And both conservative and liberal senators were responsible for putting an unheard of five holds on Bernanke’s reappointment as Fed chairman. Obama had to whip personally to get Bernanke approved.

Johnson regards the support of the central bank as reasonably secure on the left; that’s true only to the extent that you conflate, as he does, the left with the Democratic party. As we pointed out, the strained effort by Janet Yellen to rebrand herself in a New Yorker profile as a friend of the downtrodden says she’s aware of the central bank’s vulnerability on its left flank. As our correspondent Li pointed out at the time:

The piece is weirdly designed to prevent New Yorker-reader limo-liberals from joining forces with right-wingers who justifiably want to know WTF the Fed is doing.

Johnson’s bone of contention with the Fed is the way it refuses to make banks safe, boring, and smaller, as it is required to do under Dodd Frank. The critical sections of his discussion:

…senior Fed officials seem to have slipped back into their pre-2008 ways, ignoring concerns about dangerous financial-sector behavior – even when those concerns are expressed by members of the US Senate Banking Committee. This is not only unfortunate; it is also dangerous, because the Fed’s political position is much more precarious than its leadership seems to realize…

For example, the Dodd-Frank legislation specifies that all large financial institutions should draw up meaningful “living wills” – specifying how they could be allowed to fail, unencumbered by any kind of bailout, if they again became insolvent.

Creating such living wills is not an option; it is a requirement of the law. Yet, in a recent speech that reviewed the landscape of financial reform, Fed Vice Chairman Stanley Fischer skipped over the requirement almost completely….

Fischer appears to prefer to rely on the resolution powers of the Federal Deposit Insurance Corporation….Unfortunately, as currently constructed, these resolution powers are unlikely to work. They do not apply across borders, there is not enough loss-absorbing capital in large complex financial institutions, and the funding structure of big bank holding companies remains precarious.

Senior Fed officials emphasize that big banks fund themselves with more equity now than they did in the past. But the Global Capital Index constructed by Thomas Hoenig, the FDIC’s vice chairman, indicates that the largest US banks are still 95% debt-financed. With that much leverage, it does not take a lot to create fear of insolvency.

Yet, despite repeated and responsible expressions of concern – including from Senate Democrats – the Fed continues to ignore these profound problems…This is more than disappointing. It is profoundly dangerous to the economy.

Yves here. In other words, the Fed has become “independent” in the worst possible way. It shirked its oversight duties prior to the crisis (for instance, the Fed gave up supervision of primary dealers in 1992, and Greenspan announced his intention to let banks do as they wished with derivatives in 1996, despite a monster wipeout in 1994-1995 that destroyed more value than the 1987 crash) and now it thumbs its nose at performing tasks clearly and explicitly assigned to it under Dodd Frank.

Not that the Fed deserves to keep its independence, mind you. The Fed has engaged in a bad combination of political meddling and mission creep for so long that its wings should have been clipped years ago. It’s important to understand that the justification for Fed independence has become a dead letter. This is from former Fed economist Richard Alford, in a June 2008 post:

Since the first Latin American debt crisis, we have had a Fed that has been eager to lean against financial headwinds, but completely unwilling to take in sail when dealing with strong financial tail winds. The Fed did not the lean against either the NASDAQ or housing bubbles. Greenspan acknowledged that the NASDAQ might be a bubble, but decided it was appropriate to wait until the bubble popped and then mop up. Post 2000, the Fed denied the existence of a housing bubble. It ignored the declining credit standards, increased leverage, declining quality spreads and a Fed funds target below that implied by the Taylor Rule. The Fed then chose to characterize the bubble as localized froth even after it started to deflate. It then asserted that it was a contained sub-prime problem.

We have a Fed that is willing to incur short-term costs if it reduces inflation, but will not incur short-term costs to achieve financial stability or external balance. This would be less of a problem if another agency or agencies had the willingness and ability to insure financial and external balance, but it is clear that we do not. The Fed was granted independence and insulated from political pressure in order to accept short-term costs in order to enhance the prospects for long term growth. However, the current Fed, like the Fed of the 1970s, failed to use the freedom it was granted.

Assuming for the moment that the Fed either made an error of commission (spiking the punch bowl) or omission (failure to exercise its regulatory and supervisory powers), is there any reason to believe it was the result of an erosion of the independence of the Fed? Unfortunately, the public record suggests that Fed independence has been compromised. There is reason to believe that Greenspan entered into deals with two of the three administrations during his tenure as Chairman. Some commentators believe that he entered into deals with all three. However, the number is unimportant. What is important is that the Fed’s independence was compromised and a very public precedent was set. Never again will an FOMC Chairman be able to say “The Fed does not make deals” to a President or a Secretary of the Treasury or a member of Congress.

Compare the behavior of the Chairmen of the 1950s and Volcker to that of Greenspan. Chairman Eccles and McCabe both lost their Chairmanships because they wouldn’t compromise Fed independence. They stood their ground even after being summoned to the White House. Martin, appointed by Truman, was in later life referred to by Truman as “the traitor” presumably for taking the punch bowl away. The public image of Volcker is that of a man who twice a year endured public Congressional assaults, resisted political pressure, and enabled the Fed to stay the course.

Greenspan, on the other hand, jumped at the chance to meet Clinton, traveling to Little Rock before the inauguration. Bob Woodward in his book “Maestro” quotes Clinton telling Gore after the pre-inauguration meeting: “We can do business.” Woodward also quotes Secretary of the Treasury Bentsen telling Clinton that they had effectively reached a “gentleman’s agreement” with Greenspan. The agreement evidently involved Greenspan’s support for budget deficit reduction financed in part by tax increases. It is not clear what Greenspan received.

Even if the deal with Clinton contributed to a good policy mix, Greenspan should never have entered into that agreement/deal/understanding or another agreement/deal/understanding. The very act of negotiating and injecting the Fed into a discussion of budget decisions compromised Fed independence. Why shouldn’t Bush have expected the same? Why shouldn’t every succeeding President expect the Fed Chairman to be a “business” partner? Refusal to deal on the part of the Fed can no longer be attributed to principle and precedent. Refusal “ to do business” will now be viewed as a rejection, partisan or otherwise. The Fed is no longer able to stand apart from political battles. Greenspan severely compromised the Fed standing as an agency insulated from the short-sighted and partisan politics of Washington DC.

So if we were to have Audit the Fed implemented in its original version (the central bank succeeded in getting the bill considerably watered down) or have other right-left initiatives to bring a central bank that can’t shoot straight to heel, that would be a welcome development. The disconcerting part, as Johnson indicates, is that the Fed appears to think that it is invulnerable. Whether the central bank is capable of being reformed remains to be seen.